Magazine article The CPA Journal

Interest Expense of Materially Participating Purchaser of C Corp Stock Is Investment Interest

Magazine article The CPA Journal

Interest Expense of Materially Participating Purchaser of C Corp Stock Is Investment Interest

Article excerpt

In Russon v. Commissioner, a case of first impression, the Tax Court recently ruled that interest incurred on debt incurred by a materially participating employee to purchase C corporation stock is investment interest, which limits its deductibility. Russon applies to all taxpayers who incur debt to purchase a business as owner-managers rather than investors.

IRC section 163 allows a deduction for interest incurred in a trade or business; however, IRC section 163(d)(1) limits the deduction for investment interest to the amount of net investment income for taxpayers other than corporations. Investment interest is interest on debt "properly allocable to property held for investment." IRC section 163(d)(5) defines "property held for investment" as either property that produces IRC section 469(e)(1) income or an interest in a trade or business that is not a passive activity and in which the taxpayer does not materially participate. (This definition was added to the code under the 1986 Tax Reform Act. Under prior law, the Tax Court determined whether the taxpayer had a "substantial investment intent.")

IRC section 469(e)(1) income, known as portfolio income, includes "interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business." Deriving such IRC section 469(e)(1) income in the ordinary course of a trade or business would occur if the taxpayer were in the securities business.

In Russon, Scott Russon, his brother, and two cousins purchased all of the stock of Russon Brothers Mortuary, a C corporation, from their fathers for $999,000 in 1985. The younger Russons paid 10% down and agreed to pay the balance in 180 monthly payments at nine percent interest. They were employed fulltime at Russon Brothers prior to and since the purchase. Although Russon Brothers had never paid a dividend, the purchase contract contained provisions concerning the possibility of dividends.

Scott deducted the interest expense on his portion of the loan, arguing that it was incurred in a trade or business, not investment interest. He reasoned that since Russon Brothers had never paid a dividend, it had not produced any dividend income. Therefore, its stock was not property held for investment. The IRS contended that corporate stock is property held for investment whether or not dividends are actually paid. …

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